Asia Focus: Invest More, Not Save Less: Except for China, Asia in general has under-invested, not over-saved. To ensure sustained growth momentum and reduce global imbalances, Asian governments need to invest more, but preferably with less public money. This can be done by providing the right incentives and environment to private investors, and by expediting capital market development.

Economy Highlights

Hong Kong: For the second year in a row, Hong Kong is the highest growth economy in East Asia ex-China. In 2006, we expect it would maintain this position. Consumption will gradually replace exports as the key growth driver, thanks to sustained job growth and expected peak in interest rates.

Philippines: Fiscal consolidation should continue to provide the positive underlying theme. While the political picture will remain a source of market volatility, investors have demonstrated exceptional resilience and the PHP scaled cyclical highs. With a strong PHP, the BSP may need only one more 25bps hike to keep inflation in check.

Singapore: Riding on the current electronic up-cycle and a robust job market, the Singapore economy is well set for another year of solid good growth, to be supported by a mildly expansionary and electorate friendly budget.

Thailand: The next few weeks will be a testing time for Thailand. Not only may politics take interesting twists and turns, more importantly, the period will also attest how solid the country's economic fundamentals have evolved over the years. We believe Thailand will survive its current political turbulence relatively unscathed, with some occasional upside market surprises but also weaker growth momentum.

OVERVIEW

by Tai Hui

Be confident, not complacent

In recent weeks, a number of political events have become the focus in Asia, but none of them have had serious impact on the region's financial markets, nor on the real economy. This underlines not only a high level of risk appetite among investors, but also very different fundamentals in Asian politics and economics. While investor confidence will again be tested by a host of political events in the months ahead, Asia has demonstrated that it is clearly moving away from 'a place of living dangerously'.

On February 24, Philippine President Arroyo declared a 'state of emergency' on an alleged coup plot, following a number of demonstrations demanding the president's resignation. On the same day, Thailand's Prime Minister Thaksin dissolved the parliament and called for a general election on April 2, also following a number of demonstrations demanding his resignation. In both cases, public discontent was focused on alleged corruption of the leaders or their families, a cause not uncommon in Asian politics. However, no outbreak of violence was evident even in a 'state of emergency', a rare phenomenon in the Asian context even a decade ago. The 'emergency' state in the Philippines was lifted a week later after some army reshuffles and a few temporary arrests. In Thailand, the political stalemate lingers with the opposition calling for a boycott of the April 2 election, but no major upheaval or violent confrontation has occurred thus far.

Market reaction to these events is best described as muted. Asian currencies were more fixated with the trends of the Japanese yen and Chinese yuan. In fact, the PHP rose to its strongest in three-and-a-half years against the USD on March 6. Meanwhile, local bourses in Thailand and the Philippines were moving in line with the regional trend with the political events making little impression. In our view, such muted reaction can be attributed to three factors:

1. Risk appetite remains high, for now: Exceptionally low EMBI spread, relatively low VIX index and bond-swap spread are indicative of strong risk appetite amongst global investors. Loose monetary condition of the past few years has prompted such development. Yet, there are few signs of reversal thus far despite rising interest rates in the US and Asia over the past 12-18 months. A concern is whether the end of Japan's quantitative easing would be the last straw that breaks the camel's back, making investors more risk averse.
   
   
2. A more pluralistic society that fosters socio-political stability. The fact that the political events in Thailand and the Philippines have remained non-violent thus far reflects the different ecology that Asian politics is conducted these days. Not only are Asians more vocal now, and less tolerant of public office misdeeds, they are also more assertive and better organised in expressing their discontent. The development of mass media, civic organisations, education, public institution accountability and transparency, and perhaps the most important, more professional army and police forces, have all contributed to the evolution of a more pluralistic but stable socio-political environment. In the Philippines, where coup rumours are never far away, the changes in leadership in recent years have been largely peaceful. In Thailand, the last time when blood was shed during government changeover was in 1992, over a decade ago.
   
   
   
   
3. A tested economic record with promising growth prospects. Having recovered from the last financial crisis, Asia has gradually returned to its super-sonic growth path. Despite uncertainties in global economic and financial developments, Asia's track record in surviving repeated external shocks and natural calamities, its strengthened economic institutions, reinforced external positions and strong growth momentum have instilled a strong confidence among investors. Across Asia, we expect economic growth in 2006 will continue to outperform the G3. Given the strong fundamentals, any detour in the growth trajectory is likely to be temporary and represents good buy-in opportunity for investors.

Such strong underlining confidence, however, may not be sufficient to exclude all possible hiccups on our radar screen. A few risk factors, while manageable by themselves, could still cause unpleasant market disruptions, especially if get intermingled or over-neglected:

1. The end of Japan's ultra-loose monetary policy. As expected, imminent impact on liquidity was mild, but the devil could be in the details, especially given the BoJ's track record in monetary tightening.
   
   
2. Sino-US relations, which will go into overdrive in March-April, when the Schumer-Graham bill, the US Treasury report, and the state-visit by President Hu Jintao to Washington come due. While market will likely centre on the CNY, other issues like cross-strait relations, regional security, global imbalances, and access for natural resources would also come under focus.
   
   
3. Further development of the domestic political situation in Thailand and the Philippines. In Thailand, while a snap election may keep Thaksin's TRT party in power, it may not be sufficient to quell opposition disgruntlement. Other scenarios like a royal intervention or extended public restlessness should not be ruled out. In the Philippines, while the government has quickly reestablished stability following the alleged coup attempt, a crowded political agenda implies that further challenges are on the road. Risks in both countries will be discussed in the 'economy highlights' section later.

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

Invest more, not save less

- Except China, Asia has under-invested, not over-saved
- Governments need to do more investment with less public money
- Capital market development is key to channel Asia's "surplus" savings

Over the past month, several Asian governments have tabled their new budgets and grand strategies to bring their economies to more promising lands. Indisputably, good news abound. Hong Kong cheered its first budget surplus in eight years. Similarly, Singapore celebrated its return to surplus, albeit from only a marginal deficit. China launched a new five year plan to sustain its super-sonic growth through constructing a "new socialist countryside". India applauded its third year of over-charged economic growth at over 8%, second only to China.

Are these really good news, or deceptive achievements? When two of the region's highest net savers - Singapore and Hong Kong (with current account surpluses running at 8-29% of GDP) - cheered their success in restoring public sector surplus without clear direction to encourage higher private sector spending, one wonders if such policies are overly prudent? On the other hand, when the region's two largest deficit runners - China and India (with a total fiscal deficit of USD 58.5bn) - promised higher public spending to propel growth, one wonders if they have fueled the wrong engine?

There are many aspects to look at a budget. From a local perspective, the focus could be the fiscal health, economic well-being or political agenda of the specific economy or government. From a broader perspective, our concern is to what extent it contributes to more balanced and sustainable growth of the individual economy as well as the region. It is in this broader aspect that we believe Asia's finance ministers could pay more attention to and do more. Precisely, they should invest more, but preferably with less public money, more private funds, via more mature capital markets.

Under-invest, not over-save
For some years, Asia has been applauded and deplored as an over-saver. On the positive side, the region's large surplus - accentuated by its holding two-third of the world's foreign reserves, up from just one-third about 10 years ago - is lauded as a reflection of financial prudence and economic soundness. On the negative side, the same surplus is criticised as the legacy of mercantilism and the culprit of global imbalances.

The truth is, Asia as a whole is hardly an over-saver. The region's savings rate has dropped marginally from about 33% of GDP in the early 1990s to 32% in 2004. The reason Asia has saved a lot is that it has invested much less than normal, especially since the Asian Financial Crisis. Investment rate of the region has dropped from about 33% of GDP in the mid-1990s to just 22% now.

China is the only major Asian economy where savings rate has clearly increased over the years, up from below 40% in the early 1990s to near 50% recently. But strictly speaking, even China may not qualify as an over-saver given an average net savings rate (current account surplus) of about 2.5% of GDP in the past five years, only half of the region's average.

Based on the above, a natural policy response would be to encourage Asia to invest more, not to save less, with probably the only exception of China. It is in this aspect that some Asian governments might have misplaced their fiscal priorities. For instance, Hong Kong's public investment has fallen for six years in nominal value. In real terms, it has been down for nine years consecutively by a total of 40%. In the remainder of this decade, the government projects that its capital spending would stay stable in value, but down in GDP terms. However, even that may be an over-estimation, since many major projects like the West Kowloon cultural complex and construction of a new government headquarters are yet to overcome environmental and legislative hurdles. Although public investment only accounts for 15% of total investment or 3% of GDP in Hong Kong, it remains questionable whether the government has been too expedient in its pursuit for short-term budget balance at the expense of long-term investment needs. Similarly, Singapore government is budgeted to spend 15% less in development expenditure this year, after an estimated 16% drop in FY2005/06.

Within the region, public investment also suffered progressive reduction in Malaysia, Thailand, Indonesia and the Philippines over the years. However, unlike Singapore and Hong Kong, which sit on large fiscal reserves, these other economies are weighed by heavy public debt and are under pressures to restore their fiscal health, especially after suffering extended budget deficits since the Asian Financial Crisis. China and India, where demand for infrastructure is huge, the governments are hard-pressed to keep up with the funding needs, especially for rural development. For these economies, the focus of investment promotion should be placed on the private sector, which would need a different set of fiscal and public policies.

Do more with less
Throughout Asia, private sector represents the backbone of investment, including even such socialist or state-sector-heavy economies like China and India. Governments use different ways to promote investment, running from Hong Kong's do-minimum laissez-faire approach to Singapore's paternalistic industry targeting strategy, to the all-mighty state monopoly approach of China.

Over the years, the broad trend of economic liberalisation and growing concern on fiscal health have seen more and more governments taking a back seat and allowing market forces to drive investment. Deregulation and privatization have become common themes in Asian budgets and development plans. However, it is always easier said than done. Hong Kong's airport privatisation has been mulled for years, Singapore's divestment of government-linked-companies has spanned over two decades, power sector privatisation is still under study in Thailand and at very early stage in Malaysia. In India, structural reforms also seem to have slowed down. Details on privatisation, liberalization of the retail sector, and labour market reforms were absent from the new budget.

Usually, bad time breeds good policy. Indonesia's new economic cabinet installed after the mini-rupiah crisis has reaffirmed the government's commitment to accelerate privatisation. The Philippines has finally raised power tariffs and broadened the VAT base, under persistent fiscal pressures. China has started the public listing of its mega banks, ahead of the WTO-deadline for banking market deregulation. It is important that this momentum is kept beyond the tough time and be broadened to wider aspects of investment climate improvement, such as more flexible labour markets, improved investor dispute resolution, corruption reduction, and legal infrastructure development. Investment in these areas usually requires more political will and skill than hard money.

Another way to spur investment with limited public resources is to promote public private partnership. Such programs like Build-Operate-Transfer (BOT) have been widely used in infrastructure construction and should gain momentum as the region's infrastructure demand accelerates. However, for these projects to take off and be successfully implemented, a clear governance structure, transparent contract awarding process and a balanced risk-reward framework would be needed. This is especially important given the increasingly open and pluralistic societies in Asia. Hurdles encountered by Hong Kong's multi-billion cultural complex are a good example. To some extent, Thailand's mega infrastructure projects could face similar risks.

An underlying savings bias
One even more deep-seated factor behind the under-investment bias of Asian economies is their bitter experience during the Asian Financial Crisis. In the first half of the 1990s, many Asian economies depended heavily on foreign savings to fund their high-investment high-growth development model. This strategy hit the wall when foreign capital fled en masse at time of crisis. Since then, Asian corporations and households have been working hard to repair their balance sheets, building up large reserves. One may argue that given a holding of over USD 2trn foreign reserves, Asia should have rebuilt a sufficiently large cushion to allow it to spend more. While it sounds logical, the drive for more spending may remain handicapped, partly by deficit-conscious governments, and partly by the lack of deep and efficient domestic capital markets that can channel Asia's large savings into long-term investment funds. To boost investment and growth in a more sustainable way, Asian governments therefore need to not only spend smart, do more with less, but also expedite Asian capital market developments to better allocate its own savings.

HONG KONG

by Tai Hui

Consumers have the last laugh

- Hong Kong to remain the top grower in East Asia ex-China
- Consumers will join exporters to drive growth
- Jobs, interest rates and property market hold the key

For the second year in a row, Hong Kong is the highest growth economy in East Asia ex-China. In 2006, we believe it will maintain this position, albeit with a smaller margin. Aside from the current electronic up-cycle that should support Hong Kong's exports in at least H1-06, the more important growth driver this year will be consumption. Sustained job market improvement should reinforce consumer confidence, especially when interest rates peak out and the property market turns more active later this year. Our 6% GDP growth forecast for 2006, while lower than last year's 7.3%, would underline one of the best years for local consumers in the post-handover period.

For almost a decade, Hong Kong consumers had been repeatedly battered by the bursting of the property market and equity bubbles, heavy debt, high unemployment, insecure jobs, political bickering, policy mistakes and bad luck, which accumulated into the distress of the SARS period in 2003. Since then, many of these irritants have been reduced or removed, revealing a robust and sustainable recovery. Since YE-03, personal consumption expenditure (PCE) has been making a positive contribution to growth (Chart 1). In 2005, PCE contributed 2 percentage points of the 7.3% real GDP growth.

Despite generally slower growth across the region, there is still strong momentum for consumption to expand in 2006. The latest Masterindex of consumer confidence suggests Hong Kong consumers are not only upbeat from a historical perspective, but also are amongst the most optimistic in Asia, second only to Vietnam (Chart 2).

Job market: Positive trend
Underlining the strong consumption trend is sustained improvement in the labour market. Unemployment rate has fallen from the peak of 8.6% in July 2003 to the current level of 5.2%. Over the past two years, the economy has created 180,000 jobs, more than the whole civil service. Most of the new jobs come from external trade, business services, personal and social services, reflecting further swing towards a service-based economy. The services sector now employs 90% of the private workforce and accounts for 87% of the GDP. According to the Hong Kong Institute of Human Resource Management, demand for talent in engineering, telecommunication, hotel, business and professional services are still strong, suggesting more room for the unemployment rate to decline, and growing pressure to raise remuneration. For the first time since 2001, labour earnings have returned to positive nominal growth, up 3.5% in the first three quarters of 2005.

The only exception is manufacturing and construction, which employs 10% of the private workforce but hosts 28% of the unemployed. While manufacturing continues its secular decline, construction is stifled by the lack of infrastructure and housing projects. Both sectors are unlikely to create more jobs soon, but should have limited impact on overall consumption.

Property market - Engine revving?
The Hong Kong property market went through a period of consolidation in H2-05 with sideways price movement and declining transactions, on the back of rising interest rates. In coming months, interest rate trends, seasonal effect and fundamental factors could set the property market back in motion and offer consumers more to cheer about.

The current up-cycle in US interest rates and, hence Hong Kong's, is expected to end in Q2-06. This should provide a boost to market sentiment given the market is focusing more on the future direction of borrowing costs rather than the actual magnitude, which is still low from a historical perspective. Fundamentals of the real estate sector are also brightening up. Despite subdued prices, rentals continue to increase, up 5-13% in H2-05, underlining strong demand and severe supply shortages. Completion of new private housing units dropped 33% to 17,321 in 2005, a 29-year low, and is expected to fall to 17,200 and 16,400 units in 2006 and 2007. This new supply, net of pre-sold and vacant flats, implies a total supply of 44,600 units in 2006-07, barely enough to meet primary sales demand.

Finally, there is also a seasonal effect at work near term. March and April are busy months in terms of property market activity, as shown in Chart 5. The average number of transaction in March and April exceeds the average monthly transactions every year between 1999 and 2005, except in 2003 due to SARS, on average by 17%. Combining these fundamental and seasonal factors, we believe the local property prices will be well supported with upside risks. This would in turn help support consumer sentiment.

In sum, the combination of further improvement in the labour market and well supported property prices are two critical factors in keeping consumer sentiment buoyant this year. Of course, event risk, such as avian flu, should be taken into account but the robust fundamentals should ensure a speedy recovery once the impact is over.

PHILIPPINES

by Mike Moran

Resilience beyond perception

- Despite political uncertainties, sentiment remains resilient
- Market volatility 'conditioned' by fiscal improvements
- One last 25bps hike in policy rate in Q2, but PHP seems fully priced

Fiscal consolidation should continue to provide the positive underlying theme for the Philippines this year. The political picture will remain a source of market volatility but we are observing a more resilient attitude to perceived Philippine risk than in recent years. The strong peso is also helping tighten monetary policy for the BSP which has not raised policy rates since October. A sharply weaker PHP would thus be the signal for further hikes. We expect one last 25bps hike in Q2 would be sufficient to contain inflation pressures.

Déjà vu
In our December 8th update, 'Philippines: Déjà vu - All over again', we reiterated our longstanding view that although underlying fundamentals continue to make steady improvements, the market outlook still hinges on the stability, or at least perceived stability, of the political backdrop. In 2005, the Philippines started strongly, drawing record net investment inflows in the first quarter, only to see those flows subsided substantially once the likelihood of impeachment proceedings against President Arroyo began escalating by May. Foreign inflows remained flat for the rest of the year (Chart1).

This general sequence of events appeared to be developing again recently - when progress in structural reforms draws optimism from investors only to be dashed by the unpredictability of Philippine politics.

The Philippines had been making the right headlines over the past 6 months: the PHP, for instance, was the best performing Asian currency vs. the USD in 2005, up 5.92% for the year, and the 6th biggest gainer against all currencies. Year to date, the peso is up 3.58% vs. the USD, the 5th best performing currency globally so far in 2006. These gains seemed under threat following February's alleged coup attempt, planned to coincide with the 20th anniversary of the first "People Power" protests that toppled Marcos' administration, as the latest upheavals arrived on cue to complete this now well worn formula.

Exceptional resilience...
Yet investor sentiment is showing fresh resilience. Initial market reaction had been surprisingly muted as selling pressure on the PHP was shallow and short-lived. This is significant as investors are showing greater relative tolerance for political uncertainty, illustrated by the PHP's subsequent push towards a 3.5-year high and retesting 51.0 vs. the USD, even before Arroyo's 'state of emergency' measures were lifted the following week. High global liquidity levels has raised investors' risk thresholds. This is evident in other Asian markets too, like Thailand, where investors have reacted calmly ahead of the snap elections.

But this is not the only reason. While investors may be 'conditioning' themselves better with the Philippine political cycle, confidence must also be underpinned by genuine evidence of progress or else sentiment would deteriorate rapidly. We believe the Philippines has made important strides in addressing the underlying fiscal weaknesses that undermined confidence.

...supported by fiscal improvements
On the budget deficit, the figures for January's deficit fell to PHP 15.4bn, a 6% fall from a year ago. February is going to be a bumper month with the hike in VAT from 10% to 12% expected to boost revenues by up to 25% y/y. This is in line with our view for substantial narrowing in the underlying deficit this year to PHP 110bn, vs. PHP 146.5bn in 2005. A fall below 2% of GDP is now a realistic possibility in 2006, the lowest in eight years.

Nevertheless, the prospects for additional structural reforms remain unclear. The immediate political agenda will be dominated by several issues. The ongoing debate over the legitimacy of the state of emergency measures is taking up valuable time. The budget for 2006 has yet to be passed and the timetable is now looking tight with the 5-week congressional break starting April 8th fast approaching. If not passed, current spending limits revert to last year's agreed budget until the new spending proposals are agreed. A delay is possible but would not amount to a halt in public spending entirely.

The other reform focus this year was supposed to be on the constitution, paving the way for a move towards a parliamentary system and away from the current presidential one. Again, progress on this is increasingly unlikely given current congressional timetable.

But the policy deadlock need not be a big problem for now. Fiscal priority need not focus solely on introducing new taxes. One of the key problems is not the lack of taxes per se, but poor collection efficiency that has kept revenues weak. Tax revenues as a percentage of GDP remains one of the lowest by international standards. Raising this ratio back to pre-1997 levels would mean a substantial fiscal surplus (Chart 5) with which much needed spending on infrastructure, health, education and poverty reduction could be financed. Based on the more stringent collection targets imposed, improvements in efficiency are being achieved, albeit slowly.

SINGAPORE

by Joseph Tan

Time is good - for election

- An electorate friendly budget sets the tone for an early election
- Consumption to back exports and keep 2006 GDP growth at 5%
- SIBOR to stay tight at 3-3.5%, SGD to rise by 2% in 2006

Riding on the current electronic up-cycle and a robust job market, the Singapore economy is well set for another year of solid good growth, forecast at 5% in 2006. Capturing this window of opportunity to consolidate its position, the government has tabled an electorate friendly budget, probably to be followed by a general election. While a mildly expansionary budget could reinforce the economy's near-term growth momentum, the city-state has yet to tackle long-term competitiveness issues like the nurturing of a knowledge-based and entrepreneurial economy.

Party time
Notwithstanding strong growth momentum, the government has drafted a mildly expansionary budget for 2006/07 with a deficit of SGD 2.9bn, compared to an estimated surplus of SGD 0.4bn in 2005/06. While a deficit budget may be due to conservative revenue forecasts, as usually the case, on paper, the 2006/07 deficit largely comes from a SGD 2.7bn increase in special transfers, including grants, subsidies and one-off handouts. On top of that, the budget also promises to cut personal income tax rate from 22% to 21%. This electorate friendly budget, plus the submission of the election commission report to parliament, reinforced speculation that a general election is likely in H1-06.

While the new budget does not further reduce the 20% headline corporate tax rate, it has continued its selective approach by offering tax exemptions and benefits to targeted growth pillars: the finance and R&D industries. Specifically, tax exemptions are granted to select activities of REITs, trusts and insurance companies, while a SGD 5.5bn trust fund will be set up to boost R&D. Effectiveness of such industry targeting measures is yet to be verified, but their impact on fiscal position should be limited. The overall budget deficit of SGD 2.9bn represents only 1.4% of GDP.

Consumption to supplement exports
Led by stronger-than-expected pharmaceutical production in Q4-05, real GDP growth in full-year 2005 exceeded the official 5% target and reached 6.4%. A change of the GDP base year from 1995 to 2000 also resulted in an upside bias to the growth data. For 2006, the government has raised its official growth forecast from 3-5% to 4-6%, placing our 5% growth forecast right at its centre. We believe this target is achievable, given current growth momentum and a mildly expansionary budget.

The growth pattern for 2006 is likely to be the reverse of 2005. Forward-looking indicators such as US new orders for personal computers and components and the semiconductor book-to-bill ratio are exhibiting sufficient strength to carry IT exports through H1-06 (Chart 1). This contrasts H1-05 when exports suffered from a global IT correction. However, there are signs that the current IT up-cycle is starting to moderate and will slow Asian exports in H2-06. On top of this, we expect the 350bps hike in US interest rates since June 2004 would gradually curb US economic growth in coming quarters. Accordingly, this will dampen Singapore's exports and economic growth in H2-06, albeit modestly.

Amid this anticipated slowing in external demand, a shift to domestic growth drivers is expected. The current labour market is probably the healthiest in five years. Jobs created in 2005 totaled 110,800, on top of 71,400 created in 2004. This brought the unemployment rate down to 2.5%, the lowest since June 2001 (Chart 2). The number of petitions for bankruptcies has fallen to the 2001-level of 4,078 cases, cutting the non-performing loan (NPL) ratio of banks to 2%. Business receipts have increased by a healthy 11.7% y/y, after a 10.1% rise in 2004.

Interest and exchange rates to stay firm
Despite an expansionary budget and robust growth forecast, the government maintained its inflation forecast at 0.5-1.5%. This strong, non-inflationary growth environment predicted for 2006 sets an interesting stage for Singapore's monetary policy. Given the expectation of further increases in US interest rates and the close correlation between USD LIBOR and SGD SIBOR, local interbank rates are likely to face more upward pressures. However, low inflation has kept real interest rate relatively high, at about 1.7%, and dampened loan demand, especially given a cash-rich corporate sector (Chart 3). This combination of rising interbank rates and slowing loan growth will undercut bank interest margins and probably keep the 3m SGD SIBOR in a tight range of 3-3.5%.

For monetary policy, Chart 4 shows that inflation pressures are mostly external as seen by the close correlation between the import price index and WTI cushing. The impact on domestic CPI has been minimal to date, thanks to a strong SGD. The Monetary Authority of Singapore (MAS) currently has a policy of modest and gradual appreciation on the SGD which we estimate to be 2% per annum (Chart 5). With oil prices still at around USD 60 per barrel, we expect the MAS to reiterate the current policy stance at its April policy statement.

THAILAND

by Usara Wilaipich

Rough sailing, growth to slow but not stop

- Snap election does not mean the end of political tension
- Downside risks remain as uncertainty persists
- Sound fundamentals will help Thailand prevail political storm

The next few weeks will be a testing time for Thailand. Not only may politics take interesting twists and turns, more importantly, the period will also attest how solid the country's economic fundamentals have evolved over the years. We believe Thailand will survive its current political turbulence relatively unscathed, with some occasional upside market surprises but also weaker growth momentum.

Snap election - not enough
In response to repeated opposition challenges to his integrity, centered around the sales of his family-owned business Shin Corp. to Singapore's Temasek Holdings, PM Thaksin has on 24 February dissolved the Thai parliament and called a snap election on April 2. However, this move failed to quell the opposition's demand for his resignation or to stop the public from rallying on the streets of Bangkok. At this juncture, three possible scenarios may evolve:

Scenario 1: Thaksin wins the election, but fails to soothe the opposition. With the three major opposition parties joining a boycott, the election may be postponed. But this is unlikely to alter the result, given strong rural support enjoyed by Thaksin's Thai Rak Thai (TRT) party and the 90-day rule that bars any rebellious TRT party members from switching sides. This means the ruling party and Thaksin will most likely be returned to power by the election, leaving his defiant opponents on the street and political tensions to persist. Prolonged political bickering would then dampen confidence, undermine administrative efficiency and risk further delay in key projects and major policies like the privatisation of state enterprises. This would make the Bank of Thailand's optimistic 4.75-5.75% 2006 GDP growth projection more untenable, driving economic growth closer to our predicted 4.1%.

Scenario 2: rallies turn violent. Notwithstanding its remote possibility, this highly unlikely case will surely induce strongly negative market reactions. Until now, foreign investors have been main net buyers of Thai stocks, and the key driver behind a strong THB, having bought a net THB 96.3bn of Thai stocks year-to-date on top of the THB 118.5bn purchase in 2005. Much of this confidence could evaporate if a peaceful solution fails to materialise. A weakened THB could add pressure on inflation, while capital outflow en masse may strain liquidity and push up short-term interest rates. Depends on the magnitude of deterioration, GDP growth could be cut by 0.5 percentage points or more due to disrupted investment and tourism business, if the 1992 uprising is any guidance.

Scenario 3: a royal intervention. Chapter 7 of the Thai Constitution stipulates that if the country's stability is threatened during the run-up to an election, the King could intervene and appoint an interim PM to amend the constitution and ensure a fair election. If that is the case, it could cool off the mounting political tension, boost market confidence and restore socio-political stability quickly.

Sound fundamentals to limit damage
Given ongoing political uncertainties, one major concern would be the impact of prolonged political tension and sluggish economic growth on financial sector stability, especially the banking sector. In this aspect, we believe three positive factors would help:

First, bank exposure to consumer credit is limited, despite rising consumption spending by Thai consumers. Between 1998 and 2004, consumption expenditure to disposable income has risen from 82% to 90.6%. But much of this is funded by consumer savings rather than by borrowing. Outstanding consumer credit (including housing loans) remained low, totaling THB 1,022bn or 18% of commercial banks' credit as of December 2005.

Second, consumer interest burdens are still low, at 1.1% of disposable income as of end-2004. While higher interest rates will raise consumer interest burdens, it should grow only gradually as much of the borrowings are on fixed rates. Of the total consumer credit, 62% are housing loans and 11% are hire purchase. Housing loan rates are generally fixed for a certain period, while hire purchase loans are mostly fixed throughout the contract. Only the remaining 27% of personal consumption loans are subject to floating interest rates.

Third, bank profitability and asset quality have steadily improved. Bank NPLs have declined to about 9% of total loans as of end-2005, compared to near-45% during the Asian Financial Crisis. Corporate financial health has also improved significantly with average debt-to-equity ratio of about 1.0 and interest coverage of 8.7 for listed non-financial corporations at the end of Q3-05.

Externally, a sizeable USD 54bn foreign reserve and improving external payments position should also provide a cushion to major shocks. In the testing moment ahead, we will see how improved economic management over the past years could make a difference.

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